Key19 On the board's responsibility for preventing the books from being cooked

In 1993, when Leslie Fay, Inc. announced a reversal of its earnings for the previous three years, the chair of the company’s audit committee explained that the financial accounting problems were news to him. He may indeed not have known of the accounting improprieties, but why not? Perhaps he should have known.

The supervision of those who prepare the books as well as the hiring and supervision of external auditors for the company are responsibilities that rest with the board. When accounting improprieties are discovered, shareholder questions understandably arise about the board and its supervision of the officers and auditors. When sales figures are inflated, the board holds ultimate responsibility.

At the same time, it is not reasonable to expect the board to uncover every irregularity before it occurs. Even the best supervision sometimes fails.
The keys to the adequate supervision of the financial reporting systems of a corporation are as follows:

  • An audit committee comprised of independent board members
  • Regular meetings of the audit committee with discussions among members held without senior management present
  • Direct communication between the board audit committee and the company’s external auditors
  • Board supervision of the scope and extent of the external audit
  • Audit committee review of the financial reports of the company before those reports are released to the public, including detailed looks at the rationale and reasoning in the segments of the financial reports that explain the numbers, called management’s discussion and analysis
  • Head of the company’s internal audit area reports directly to the CEO and has access to the board
  • Adequate supervision of the company’s internal audit function including:
    1. Policies on what employees can audit, which areas and a rotation of those assignments
    2. Outside evaluation of the internal audit department of the company
    3. Adequate budget, resources and staffing for the internal audit department
    4. Logical scheduling of internal audits and priorities for completion of audits
    When meeting independently with the company’s outside auditors, the board audit committee should question them as follows:
    • Did the external auditors have any disagreements with management on the financial reports?
    • Did the external auditors find any material weaknesses in the company’s internal control systems and were those weaknesses reported to senior management? What was the response? Are steps being taken to resolve the problem? Does senior management support the recommendations?
    • Did senior management seek or obtain opinions from other external auditors on the financial statements? What issues were addressed by the additional auditors?
    • Have the company’s computer systems been reviewed to determine whether adequate controls are in place?
    • How many former employees of the outside audit firm does the company employ and vice versa?
    • What percentage of the outside auditor’s business is the company’s account? This factor can influence the independence of the auditor.

The board is an external force that can play a critical role in assuring the accuracy of the company’s financial statements. Recently, Warren Buffett reflected dismay at the erosion of the transparency of financial statements in the United States. He bemoaned the fact that the United States has always been known for its accurate reflection of corporate company performance but said that management creativity is booking earnings and postponing expenses had become so common that it constituted a “distortion du jour.”


The result of such manipulation of financial results is the erosion of investor trust. Mr. Buffett joined with SEC Chairman Arthur Levitt in calling for the American Institute of Certified Public Accountants boards and senior management to self-regulate and provide financial statements that reflect accurately the financial status of the corporation. The board is a check point for halting the distortions fu jour in the publicly-released financial statements of a firm.

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